Modligiani and Miller's Capital Structure Theory

Capital structure decisions: To M&M and beyond Introduction Modigliani and Miller’s proposition one states that by introducing debt financing does not change the value of the firm or the value of the firm’s cash-­‐flows but only the way that these cash-­‐flows of the firm are split between its debt and equity holders. This is the principle of conservation of value: “no change in the investment value of the enterprise as a whole would result from a change in its capitalization.”[1] Therefore, the value of the firm is equal to the value of its debt plus its equity. V = D + E Modigliani and Miller’s proposition two states that by introducing debt financing does not change the cost of capital to the firm but merely changes the way risk is divided between debt-­‐holders and equity-­‐holders. This is the principle of conservation of risk. Because debt has a prior claim on the firm’s cash-­‐flows, the introduction of debt increases the risk to shareholders since shareholders’ returns come after those of debt-­‐holders. This is effectively a transfer of risk from debt to equity – because debt claims come before those of equity (for the same firm) debt will